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INTERNATIONAL
FINANCIAL
MANAGEMENT
Seventh Edition
EUN / RESNICK
2-0
Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
The International
Monetary System
Chapter Objective:
2
Chapter Two
INTERNATIONAL
FINANCIAL
MANAGEMENT
This chapter serves to introduce students to the
institutional framework within which:
•  International payments are made. Fourth Edition
EUN / RESNICK
•  The movement of capital is accommodated.
•  Exchange rates are determined.
2-1
Chapter Two Outline
l 
l 
l 
l 
l 
l 
l 
l 
l 
2-2
Evolution of the Int’l Monetary System (Not 4 Exam)
Current Exchange Rate Arrangements
European Monetary System (Not 4 Exam)
The Euro (€) and the European Monetary Union
The Mexican Peso Crisis (1994) (Not 4 Exam)
The Asian Currency Crisis (1997-98) (Not 4 Exam)
The Argentine Peso Crisis (2002) (Not 4 Exam)
European Crisis (2009-?)
Fixed vs. Flexible Exchange Rate Regimes
1
Evolution of the
International Monetary System
Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
l  Interwar Period: 1915-1944
l  Bretton Woods System: 1945-1972
l  Flexible Exchange Rate Regime: 1973-Present
l 
l 
2-3
Bimetallism: Before 1875
l 
l 
l 
A “double standard” in the sense that both gold and silver
were used as money
Some countries were on the gold standard (e.g., U.K. after
1816), some on the silver standard (e.g., Germany), some
on both (e.g., France till 1873)
Gold & silver were used as international means of payment.
n 
l 
Exchange rates among currencies were determined by either their
gold or silver contents
Gresham’s Law implies that it is the least valuable metal
that would tend to circulate.
n 
2-4
Why? Weights (metal contents) are fixed, so…
Classical Gold Standard:
1875-1914
l 
During this period in most major countries:
Gold alone was assured of unrestricted coinage
There was two-way convertibility between gold and
national currencies at a stable ratio.
n  Gold could be freely exported or imported.
n 
n 
l 
The exchange rate between two countries’
currencies was determined by their relative gold
contents.
2-5
2
1875-1914
For example, if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold, and the British pound
is pegged to gold at £6 = 1 ounce of gold, then it
must be the case that the exchange rate is
determined by the relative gold contents:
$30 = £6
$5 = £1
2-6
1875-1914
l 
There are advantages:
The highly stable exchange rates under the classical
gold standard created, before WWI, an environment
that was conducive to international trade and
investment.
n  Misalignment of exchange rates and international
imbalances of payment were automatically corrected
by the price-specie-flow mechanism.
n 
2-7
Price-Specie-Flow Mechanism
l 
l 
Suppose Great Britain exported more to France
than France exported to Great Britain.
This cannot persist under a gold standard.
n 
n 
Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great Britain.
This flow of gold will lead to a lower price level in France and, at
the same time, a higher price level in Britain.
u  Money
l 
is backed by gold, so the domestic stocks of money rise or fall
(Because the FX rates are fixed) the resultant change in
relative domestic price levels will slow exports from Great
Britain and encourage exports from France.
2-8
3
1875-1914
Periodically, a return to the gold standard is
advocated…
l  …but the standard has two major shortcomings:
l 
n 
Money can be printed only if there is gold to back it
u  The
supply of newly minted gold is so restricted that the
growth of world trade and investment could be hampered for
the lack of sufficient monetary reserves.
n 
Moral hazard
u  Even
if the world returned to a gold standard, any national
government could abandon the standard.
2-9
Interwar Period: 1915-1944
Exchange rates fluctuated as (post WWI)
countries widely used “predatory” depreciations
of their currencies as a means of gaining
advantage in the world export market.
l  Attempts were made to restore the gold standard,
but participants lacked the political will to
“follow the rules of the game”.
l  The result for international trade and investment
was highly detrimental.
l 
2-10
Bretton Woods System:
1945-1972
Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
l  The purpose was to design a postwar international
monetary system.
l  The goal was exchange-rate stability without the
gold standard.
l  The result was the creation of the IMF and the
World Bank.
l 
2-11
4
1945-1972
l 
Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce
n 
Other currencies were pegged to the U.S. dollar.
Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par
value by buying or selling foreign exchange
reserves as necessary.
l  The Bretton Woods system was a dollar-based
gold exchange standard.
l 
2-12
1945-1972
German
mark
British
pound
r
Pa lue
Va
French
franc
P
Va ar
lue
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
2-13
Problems with Bretton Woods.
l 
More flexible than gold-based system
l 
But: U.S. must be willing to supply $ to ROW.
n 
n 
n 
Physical gold quantity limits do not hamper growth
i.e., the U.S. must be running a current-account deficit.
This is known as the Triffin paradox:
u  U.S.
l 
CA deficit is needed, yet it may cause the system’s demise
What happens if the U.S. does not have enough
gold to back up the dollar?
n 
2-14
Run on gold? (De Gaulle, 1960’s)
5
Today’s Analogy with Bretton Woods.
l 
The U.S. dollar itself is the reserve asset
n 
n 
l 
“hard” currencies make up 90%+ of official reserves
USD makes up 62%+ of all FX reserves (68% of est. Chinese ones)
But: U.S. must be willing to supply $ to ROW.
n 
n 
i.e., the U.S. must be running a current-account deficit.
This CA deficit is what provides the world with liquidity
u 
u 
l 
there is no physical limit to supply of dollars (unlike gold)
Illustration: FT article by Martin Wolf, Oct. 2009
This “System” could keep working as long as
n 
n 
n 
U.S. are willing to let foreigners build up claims on it
U.S. inflation is low
Other countries are willing to hoard U.S. dollars (Economist_06h)
2-15
The Flexible Exchange Rate Regime:
1973-Present (Back to Exam Material)
l 
Flexible exchange rates were declared acceptable
to the IMF members (effectively 1973; formally 1976)
n 
Central banks were allowed to intervene in the
exchange rate markets to iron out “unwarranted”
volatilities
Gold was abandoned as an international reserve
asset (dollar not convertible into gold any more)
l  Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds
l 
2-16
Current Exchange Rate Arrangements
l 
Free Float (most flexible)
n 
The largest number of countries, about 48, allow market forces to
determine their currency’s value (e.g., U.S., U.K., Sweden)
l 
Managed Float
l 
Pegged to another currency
n 
n 
n 
l 
About 25 countries combine government intervention with market
forces to set FX rates (e.g., China (?), S’pore, Tunisia, Switzerland)
Such as the U.S. dollar or euro (through franc or mark)
Crawling bands (e.g., Israel, Romania) to crawling pegs to pegs
with horizontal bands (e.g., Denmark) to fixed pegs (e.g., China
and Malaysia till July 2005) to currency board (e.g., Hong Kong)
No national currency (least flexible; Economist-06k)
n 
2-17
Some countries do not bother printing their own, they just use the
U.S. dollar (e.g., Ecuador, Panama, & El Salvador have dollarized)
6
Exchange Rate Determinants
in a Free Float
l  What
determines the equilibrium spot
exchange rate in a free float?
n  Supply
and demand of foreign currency.
u  Trade
in goods and services
n  Impact of inflation?
u  Attractiveness
of financial assets
n  Expectations
u Liquidity
u Short
term vs. long term (overshooting)
2-18
Central Bank Intervention
l  Official
reserves
l  Sterilized vs. unsterilized intervention
n  Open
market operations (fixed-income market)
u  Either
to mop up excess domestic liquidities
n  Following an intervention pushing down the local currency,
oversupply of domestic currency à CB sells bonds mop up
u  Or
to increase liquidity
n  Following an effort to prop up the local currency,
sterilization = “CB prints money & uses it to buy back bonds
l  Do
central banks need FX operations? E_06a
2-19
Central Bank Effectiveness
l  Intervention
u Theory:
n  Affects relative D&S of domestic vs. foreign assets
n  Signaling, if they are not kept secret
u  But,
mixed evidence that they are successful
l  Communications
u Theory:
n  Could help coordinate the perceptions of traders
u  In
2-20
practice, seem to change rate levels and volatility
7
European Monetary System
and Union, ECU and Euro
l 
The next 9 pages (including graphs)
are NOT Exam Material
2-21
1979-1999
A set of European countries maintain exchange
rates among their currencies within narrow bands,
and jointly float against outside currencies.
l  Objectives:
l 
To establish a zone of monetary stability in Europe.
To coordinate exchange rate policies vis-à-vis nonEuropean currencies.
n  To pave the way for the European Monetary Union.
n 
n 
2-22
What Is the Euro?
The euro is the single currency of the European
Monetary Union which was adopted by 11
Member States on January 1st, 1999
l  The original member states were:
l 
Austria, Belgium, Luxembourg, Netherlands, France,
Germany, Italy, Ireland, Spain, Portugal, Finland
l 
Now add to that set:
Greece, Slovenia, Malta, Cyprus, Slovakia, Estonia,
Latvia
2-23
8
Euro Area
23 Countries “participating” in the euro:
Austria
Belgium
Cyprus
Czech Republic
Denmark
#17 = Estonia
Finland
France
Germany
Greece
Hungary
Ireland
Italy
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
2-24
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
l 
#18 = Latvia
Lithuania
Luxembourg
Malta
Netherlands
Poland
Portugal
#16 = Slovakia
Slovenia
Spain
Sweden
UK
EURO CONVERSION RATES
1 Euro is Equal to:
2-25
40.3399 BEF
Belgian franc
1.95583 DEM
German mark
166.386 ESP
Spanish peseta
6.55957 FRF
French franc
.787564 IEP
Irish punt
1936.27 ITL
Italian lira
40.3399 LUF
Luxembourg franc
2.20371 NLG
Dutch gilder
13.7603 ATS
Austrian schilling
200.482 PTE
Portuguese escudo
5.94573 FIM
Finnish markka
l
What is the official sign of the euro?
l 
The sign for the new single currency looks like an
“E” with two clearly marked, horizontal parallel
lines across it.
€
l 
It was inspired by the Greek letter epsilon, in
reference to the cradle of European civilization
and to the first letter of the word 'Europe'.
2-26
9
What are the different denominations
of the euro notes and coins ?
There are 7 euro notes and 8 euro coins.
€500, €200, €100, €50, €20, €10, and €5.
l  The coins are: 2 euro, 1 euro, 50 euro cent, 20
euro cent, 10, euro cent, 5 euro cent, 2 euro cent,
and 1 euro cent.
l  The euro itself is divided into 100 cents, just like
the U.S. dollar.
l 
l 
2-27
How did the euro affect contracts
denominated in national currency?
l 
All insurance and other legal contracts continued in force
with the substitution of amounts denominated in national
currencies with their equivalents in euro.
2-28
Value of the Euro in U.S. Dollars
January 1999 to 2014: Ups & Downs…
2-29
10
Value of the Euro in Yen
January 1999 to 2014: Wild rides!
2-30
& Union; ECU and Euro
l 
Back to Exam Material !
2-31
The Long-Term Impact of the Euro
l 
l 
Euro success ßà political integration of Europe?
It is possible that the U.S. dollar will lose its place
as the sole dominant world currency;
n 
Chinese, S. Korean and Japanese central banks stated
(in 2005) that they might start to diversify out of dollars
u Evidence?
àSwedish CB did so in 2006 (FT, April 22 2006); Others?
n 
l 
Would it matter if the Chinese moved out of dollars?
The euro and the U.S. dollar might share the role
of the world’s major currency (what about Yuan?)
2-32
11
How likely is the Euro to succeed?
l 
Benefits of monetary union:
Reduces FX risk
Cuts transactions costs (direct costs + hedging costs)
n  Merges markets, increases liquidity, reduces WACC
n 
n 
l 
Costs of monetary union:
n 
n 
Loss of economic policy independence (Greece!)
FX rate vs. monetary policy vs. fiscal policy (Greece!)
u Solution
to self-made mess? Competitive devaluation impossible
(Italy’s old way) (Greece!) Solution? tax labor more, firms less
u Response to “asymmetric shocks” – i.e., the question is not trivial
& the answer is relevant to FX risk in non-euro countries
2-33
Costs of (any) Monetary Union
l 
The main cost of monetary union is the loss of
national monetary and exchange rate policy
independence.
The more trade-dependent and less diversified a
country’s economy is, the more prone to asymmetric
shocks that country’s economy would be
n  Particularly relevant for less-diversified economies
n  Is this what is happening now in the Euro zone?
n 
u Contrast
the performance of Germany with the periphery’s
Cut wages?
u Solution?
2-34
Costs of (any) Monetary Union
l 
Take the example of Texas, Oklahoma, etc.
n 
n 
Those states are on a “dollar peg”
Their economies are dependent on gas and oil
u  if
oil prices rise substantially on the world market, they cannot
adjust monetary or FX policies
-> inflation goes up
u  if the price of oil falls precipitously -> they get into a slump
n 
l 
Similar for Middle Eastern countries (pegged to US$)
By contrast, it must be that the benefits of
European monetary union usually outweigh costs
n 
2-35
Counterexamples? Latvia 2009? Greece 2010!
12
The Mexican Peso Crisis (1994)
(Not Exam Material)
On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14%.
l  This decision changed currency trader’s
expectations about the future value of the peso.
l  They stampeded for the exits.
l  In the rush to get out, the peso fell by 40%+
l 
2-36
The Mexican Peso Crisis
l 
The Mexican Peso crisis is unique
n 
l 
It was the first serious international financial crisis
touched off by cross-border flight of portfolio capital.
Two lessons emerge:
It may be essential to have a multinational safety net in
place, to safeguard the world financial system from
such crises (debate on the role of the IMF, anyone?)
n  An influx of foreign capital can lead to an overvaluation
in the first place
n 
2-37
The Mexican Peso Crisis
l 
Comparison to the U.S. situation today?
n 
Easy access to cheap foreign credit.
u Mexico
u The
n 
financed its development mostly with foreign capital;
U.S. are financing their trade deficit with foreign funds.
Let the good times roll in domestic credit markets:
u Mexico:
u United
n 
All that is needed for a painful adjustment is a change
in foreign investors’ expectations.
u So
2-38
easy credit policy.
States?
far, however, this has not happened. Tomorrow?
13
The Asian Currency Crisis (1997)
(Not Exam Material)
Capital markets opened
à large inflows of private capital à credit boom
l  Fixed or stable exchange rates encouraged
unhedged financial transactions and excessive risktaking (by both borrowers and lenders)
l  The real exchange rate rose à export slowdown
l  Japan’s recession (and concomitant ¥ depreciation)
compounded domestic problems.
l 
2-39
2-40
l 
The Asian currency crisis in 1997-1998 turned
out to be far more serious than the Mexican crisis
n 
n 
in terms of the extent of the contagion
and in terms of the severity of the resultant economic
and social costs
Many firms with foreign currency bonds were
forced into bankruptcy
l  The region experienced a deep, widespread
recession
l 
2-41
14
The Argentinean Peso Crisis (2002)
(Not Exam Material)
l 
In 1991, the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity (1-1)
l 
The initial economic effects were positive:
n 
n 
l 
Argentina’s chronic inflation was curtailed
Foreign investment poured in
As the U.S. dollar appreciated on the world
market, the Argentine peso became stronger too
2-42
The Argentinean Peso Crisis
l 
The strong peso hurt exports from Argentina and
caused a protracted economic downturn that led to
the official abandonment of the peso–dollar parity
in January 2002.
n 
n 
2-43
The unemployment rate rose above 20 percent
The inflation rate reached a monthly rate of 20 percent
The Argentinean Peso Crisis
l 
There are at least three factors that are related to
the collapse of the currency board arrangement
and the ensuing economic crisis:
Lack of fiscal discipline
Labor market inflexibility
n  Contagion from the financial crises in Brazil and Russia
n 
n 
2-44
15
The USA & China (Not Exam Material)
2-45
The USA and China
China maintained a fixed exchange rate between the renminbi (RMB) /
yuan and the U.S. dollar for a long time.
n  RMB floated between 2005 and 2008 and again starting in 2010.
Pressure from China’s trading partners for a stronger RMB.
l 
l 
2-46
Crisis in European Periphery (2009-?)
l 
There are at least three factors that may be related
to the run on currencies and the economic crisis:
n 
n 
Lack of fiscal discipline? Some (e.g., Hungary)
Credit boom
u US:
in a downturn, the money tide goes out and a lot of people
were shown to have been “swimming naked”
u EE: not only did EE firms and residents borrow a lot, they
borrowed in foreign currency (SF and Euro)
n  This carry trade, predicated on the assumption of an eventual
accession to the euro, turned out deadly.
u EMU
2-47
Periphery: on top of it, borrowed funds invested in RE
16
“PIIGS” Crisis (Winter 2010-?)
l 
Who?
l 
What happened?
n 
n 
Portugal, Italy (?), Ireland, Greece, Spain
Investor sentiment?
u  If
so, what’s the fix?
n  Short sales restrictions? Ban CDS?
n  Fix fundamentals?
l  Risk of tightening the belt too much àspiral à default
n 
Fundamentals! Lack of fiscal discipline
u  Crucial
2-48
for monetary union
Int’l Investment Positions (% of GDP)
2-49
Currency Crisis Explanations
l 
l 
l 
l 
In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies. In the long run.
In the short run, currency traders’ expectations play a
much more important role.
In today’s environment, traders and lenders, using the most
modern communications, act by fight-or-flight instincts.
For example, if they expect that others are about to sell
Brazilian reals for U.S. dollars, they want to “get to the
exits first”.
Thus, fears of depreciation can be self-fulfilling prophecies
2-50
17
Currency Crisis Prevention?
l 
Precautionary savings
n 
n 
Relevant to households?
Relevant to firms?
u  IBM,
Berkshire Hathaway, Apple, etc.
borrowed at 15% from BRK in 2009, but a year later
was able to tap the market at 6%
u  Harley-Davidson
n 
Relevant to countries
u An
explanation for emerging-market and BRIC FX reserve
accumulations?
n  Risk of dual run (on local banks and on currency)
n  Implications for US BOP?
n  05b_Economist , January 2009
2-51
Fixed vs. Flexible
Exchange Rate Regimes
l 
Arguments in favor of flexible exchange rates:
n 
n 
Easier external adjustments.
National policy autonomy.
u  “Trilemma”:
n  you can have only two of (i) a fixed FX rate; (ii) free international
flows of capital; (iii) an independent monetary policy.
n  Example: Economist_06bb.
l 
Arguments against flexible exchange rates:
n 
n 
Exchange rate uncertainty may hurt international trade
No safeguards to prevent crises
2-52
Fixed vs. Flexible
l 
Example to compare both regimes :
n 
n 
Suppose the exchange rate is $1.40/£ today.
In the next slide:
u  we
u  far
l 
l 
see that the demand for British pounds
exceeds the supply at this exchange rate
The U.S. experiences trade deficits.
Key question:
How is the trade deficit eliminated
under either regime?
2-53
18
Fixed vs. Flexible
Dollar price per £
(exchange rate)
Supply
(S)
Demand
(D)
$1.40
US. CA deficit
S
2-54
Q of £
D
Flexible (as opposed to Fixed)
Under a flexible exchange rate regime, the dollar
will simply depreciate to $1.60/£, the price at
which supply equals demand and the trade deficit
disappears.
2-55
Flexible (as opposed to Fixed)
Supply
(S)
Dollar price per £
(exchange rate)
l 
$1.60
$1.40
Demand
(D)
Dollar depreciates
(flexible regime)
Demand (D*)
D=S
2-56
Q of £
19
Fixed (as opposed to Flexible)
Exchange Rate Regime
Instead, suppose the exchange rate is “fixed” at
$1.40/£, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
l  The government would have to shift the demand
curve from D to D*
l 
n 
In this example this corresponds to contractionary
monetary and fiscal policies.
2-57
Dollar price per £
(exchange rate)
Fixed (as opposed to Flexible)
Exchange Rate Regime
Supply
(S)
Contractionary
policies
(fixed regime)
Demand
(D)
$1.40
Demand (D*)
D* = S
Q of £
2-58
Exchange Rate Determinants (FF)
l  What
determines the equilibrium spot
exchange rate in a free float?
n  Supply
and demand of foreign currency.
u  Trade
in goods and services
n  impact of inflation?
u  Attractiveness
of financial assets
n  Expectations
u Short
term vs. long term
u liquidity
2-59
20
End Chapter Two
2-60
21

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